This P/E Suggests Direct Line Insurance Group PLC Is A Buy

The FTSE 100 has risen by more than 80% since it hit rock bottom in 2009, and bargains are getting harder to find.

I’m on the hunt for companies that still look cheap, based on their long-term earnings potential. By comparing a company’s current share price to its average historical earnings, you can see whether it looks cheap, compared to its past performance.

Today, I’m going to take a closer look at the earnings of recently-floated FTSE 250 member Direct Line Insurance Group PLC (LSE: DLG).

Is Direct Line a buy?

Direct Line’s share price has risen by 15% since it floated in October 2012, so do its past earnings justify the increase in its market value?

In the table below, I’ve calculated Direct Line’s trailing twelve-month P/E ratio.

I’ve also included a P/E ratio calculated using Direct Line’s current share price, and the average of its normalised earnings from the last four years plus its 2013 forecast earnings, which I’ve called the PE5.

I’d normally use 10 years’ earnings for this (PE10), but these figures aren’t readily available for FTSE newcomer Direct Line, so I’ve reduced my usual timeframe:

Direct Line
Insurance Group
9.2 16.9

Direct Line reported a thumping £271m loss in 2010, which dragged down its average earnings per share, resulting in a PE5 of 16.9, nearly double the firm’s trailing P/E of 9.2.

However, a P/E of 16.9 is in-line with the FTSE 250 average of 17.3, and Direct Line has another trick up its sleeve, which may tip the balance in its favour.

Income potential

The insurance sector is a favourite for income, but previous high yielders, such as RSA Insurance, have cut their payouts over the last year, disappointing investors.

Direct Line currently offers a dividend yield of 5.6%, and the firm’s final payout this year is expected to rise to 8.5p, giving a prospective yield of 5.9% — double the FTSE 250 forecast average of 2.9%.

FTSE 100 promotion candidate?

Direct Line’s market capitalisation of £3.25bn means that is larger than the bottom five FTSE 100 members. I believe that the firm could be promoted into the FTSE 100 in the next year or so, which could lead to further share price gains, as big tracker funds purchase the stock.

In my view, Direct Line is an attractive buy for income at present, with the potential for further capital gains.

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> Roland does not own shares in any of the companies mentioned in this article.